Individual security weights are driven by combining our notion of future profits and our forecast of risk, the ultimate process by which we create portfolios. We seek to maximize expected return while minimizing risk — tracking error in our benchmark-relative work; total volatility in the case of our managed-volatility and absolute-return strategies. We employ commonsense rules to minimize risk — sector, industry, country, beta, and market-cap guardrails, as well as specific-risk and liquidity-limited stock positions. In addition, we consider four other categories of factors to manage our active risk exposure:
Countries — Exposure is controlled or neutralized.
Industries — Within sectors, exposure is controlled but is not neutralized.
Market Cap — Capitalization risk is managed at the portfolio level.
Fundamental Characteristics — Elements of value, management, and momentum are used to predict risk associated with stocks’ financial characteristics.
Market-Based Factors — Stocks’ sensitivity to broad market movements, volatility, and their responsiveness to fluctuations in the foreign-exchange market matter.
Based on the influence of these factors, risk is controlled at the portfolio level via a predicted beta guardrail.
The most important determinant of a security’s weight (including negative weights on the short side) is our forecast of future profits. Although we seek to squeeze out every penny of excess return, we also seek to balance multi-faceted risk.